Mastering the Tax Buckets: A Smarter Way to Grow Your Wealth
What is the major expenditure on your paycheck? Mortgage, Kid's education, Kid's activities, Vacation, Shopping ?
It's none of the above. It's the taxes. If you are salaried employee, first the federal and state income taxes are taken before giving you the paycheck. When you invest the money, you got after taxes and the money grows, you pay the taxes again on the growth based on the investment type. Considering all this, managing taxes smartly is the best way to save a lot of money in the long term. We are not talking about evading taxes here. Let's not plan our personal meet in a prison:-) We are just talking about legally paying the minimum tax possible by smartly investing the money.
When it comes to investments, they are subjected to 3 types of tax treatments.
- Taxed Now
- Tax Deferred
- Tax Advantage
Taxed Now
The money in the "Taxed Now" bucket is the liquid money you have in the bank, money invested in stocks, mutual funds, and other market investments. These investments are done with your after-tax money. But any interest earned on your liquid cash, dividends on stocks and mutual funds are taxed again. When you sell stocks for profit you pay the short term/long term capital gain taxes on the profits.
Tax Deferred
This is your Traditional IRA, 401(k) accounts. You haven't paid tax on this. You have built these accounts with pre-tax money. When you withdraw money from these accounts during retirement, you pay taxes on the principal and growth. The tax you pay depends on your total income from all taxable sources at that point of time.
Tax Advantage
These are your investments with post tax dollars. These accounts are never taxed again. These investments are called tax because of future tax treatment.
ROTH IRA, Cash Value life insurance (7702 Plan) comes into this category.
Let's view the 3 tax buckets we discussed.
When you have just started your earnings, it's OK to have your money in Taxed Now bucket. But during the accumulation phase you need to start filling your Tax deferred bucket and Tax-Advantage bucket. As you cross the midlife you need to aggressively build your t. By moving major portion of your assets into tax advantage bucket, you are eliminating the impact of tax increases. Though we crib a lot about taxes, remember that we are on the lower side of taxes in the history of the United States. As of writing this article, the highest tax bracket is 37%. But guess the highest tax bracket in the history of the United States. It's 94% !! This happened after 2nd world war to cover the losses from the war and rebuild the infrastructure. We might not see that kind of taxes again, but considering USA at 36 trillion debt and counting, taxes can only go up in the future.
Right distribution of assets in these 3 buckets
Imagine pouring your funds accumulate in these 3 buckets in 3 levels. First level, pour the funds from Tax A bucket and in second level pour funds from your Tax deferred bucket and in 3rd level from you Tax Now bucket. How does the shape look like. If its look like a pyramid below, then, you have built a strong financial tax pyramid.
If your structure is looking like an inverted pyramid, it's time to think and act on it. It takes time to do it in optimal way.
That's a warp this week. Happy learning!
